The military genius Sun Tzu said, “Every battle is won before it is ever fought.”
I'm not sure how many kids Sun and the missus sent off to State U., but his wisdom is easily applied to the process of paying for college. The key to helping clients meet their higher education expenses lies in getting them to take definitive action in the years preceding enrollment.
Last month's column outlined the preparations clients and advisors should make through the child's early adolescent years. This month addresses the teenage years, including tips on maximizing a family's financial aid when the child is ready to enter college.
Before securing need-based financial aid, clients need to determine the portion of college costs that will come out of the family's pockets. The first step in determining the Expected Family Contribution (EFC) is filling out the Free Application for Federal Student Aid, or FAFSA. If an advisor is unfamiliar with the thick stack of forms required, he can get to know them online at fafsa.ed.gov.
The acquired expertise will be mutually beneficial: Parents only go through this arduous process a couple of times and will appreciate an advisor's battle-tested insight. And as part of the routine, you'll get to review their income tax returns, finding more ways you can help them achieve their goals.
An advisor needs to make sure his clients submit the form as early as they can — usually in January of the student's senior year in high school. Most aid is delivered on a first-come, first-served basis, so any delays could cost clients dearly.
Am I FM or IM?
Financial aid awards are calculated via two different methods.
The first, called Federal Methodology (FM), is used to determine all federal aid, including subsidized loans, grants and state scholarships. It's the more lenient of the two and is generally used by public institutions to determine need.
The second, Institutional Methodology (IM), is employed on top of the FM by most private — and therefore more expensive — schools. This calculation determines how much help each individual school may give to a family. Important differences from the FM include:
- Losses and depreciation must be added back to income.
- Factoring in child- and elder-care expenses is permitted.
- Home equity is counted as a parental asset.
Closing the sale
If the clients have non-IRA positions with larger profits and are thinking about selling the securities, try to complete the transaction during the calendar year in which the child becomes a high school junior. Wait any longer, and the realized gains will show up as “income” on the financial aid request, artificially boosting the family's apparent earnings and potentially disqualifying them from a good chunk of assistance.
Slashing earnings to boost aid
Clients with the ability to adjust their income upward and downward (small-business owners, for instance, or those living off of their portfolios) should pay special attention to the Simplified Needs Test — geared generally toward families with incomes less than $50,000 who file with form 1040A or 1040EZ.
According to the calculators at finaid.org, a middle-aged couple with $100,000 in home equity, $100,000 in other assets and adjusted gross income of $40,000 may be required to kick in just a couple hundred dollars before they receive any financial aid.
But if the same couple earned just $10,000 more, their new EFC responsibility would be over $3,000. In other words, each extra dollar earned cost them almost 30 cents in financial aid, plus the extra income and payroll taxes.
If the child has legitimate earned income during the pre-college years, clients should open a Roth IRA for the prospective student. Because the money is deposited in a retirement account, it's not included in the EFC, and therefore won't reduce any aid.
That doesn't mean the student's Roth IRA can't be used for paying for college. Contributions to a Roth IRA can of course be withdrawn at any time, for any reason, with no tax or penalty. But since contributions removed may be included as part of the student's income in the next year's financial aid request, it makes the most sense to wait until the student's senior year in college to tap into the account.
Under the FM and IM, stocks, bonds and mutual funds owned by parents outside of IRAs and 401(k)s will reduce any financial aid offered by as much as 5.6 percent of the account value per year. A small percentage, yes, but a half-million dollar portfolio would put the parents on the hook for around $25,000 each year before they get any assistance.
One way to get the money and spend it, too, is to make any planned big-ticket purchases before the family completes the FAFSA. Paying off a mortgage will help reduce the EFC under the Federal Methodology, and closing out credit card balances will eat up cash that would otherwise be attached under both methods of calculation.
What about the “ideal” clients — those with six- or seven-figure nonretirement portfolios and no debt? Advisors may still be able to substantially increase the aid awarded to families who meet the following criteria:
- Parents in their mid- to late 50s.
- Students applying to schools that use the FM.
- Families with no immediate need for portfolio income or assets.
The solution? Transfer the nonretirement assets to a tax-deferred annuity, before the family fills out the FAFSA. The Federal Methodology formula doesn't consider tax-deferred annuities as a source of funds, so they won't be included in the parents' available assets.
Better yet, the aid packages in future years won't be reduced by portfolio dividends and interest, up to 40 percent of which may have otherwise been included in the EFC.
Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com